Here Are 7 Ways People Screw Up Their 401(k)s
Life + Money

Here Are 7 Ways People Screw Up Their 401(k)s

The go-to method of retirement saving for most white collar American workers these days is the company-sponsored 401(k) plan. Workers benefit from an easy, tax-favored way to sock away money. But the plans are not fool-proof, and they’re full of pitfalls that could trip up the novice investor. For four in 10 workers, 401(k) accounts represent their only retirement savings, according to Fidelity.

Here are the seven of the biggest mistakes made by 401(k) investors:

1.     Not investing enough. The minimum anyone should invest in his 401(k) plan is enough to get any potential employer match, offered by some 80 percent of companies. The average employer contribution amounts to 4.3 percent, averaging about $3,500 per employee per year, Fidelity reports. You’ll have to put far more than that into your 401(k), however, to have a nest egg that will support a retirement that could last 30 years or more. 

Financial planners say workers should be saving at least 10 percent of their income for retirement. Older workers who have gotten a late start may need to save even more than that. “People need to prioritize retirement savings much higher than they currently do,” says Greg McBride, chief financial analyst at Bankrate.com.

Workers can contribute up to $18,000 in pre-tax dollars to their 401(k) plans in 2015, with workers age 50 and over able to put in an additional $6,000 “catch up” contribution. One easy way to increase your savings is to sign up for auto-escalation, a benefit offered by a growing number of employers. It will automatically ratchet up your contribution by a pre-determined rate every year. If you don’t want to commit to that, consider increasing your contribution manually whenever you get a raise; that way it will be less noticeable in your paycheck.

Related: Are 401(k) Plans Setting Up Millennials for Pain?

2.     Tapping into it too early. You can take a penalty-free withdrawal from your 401(k) at age 59 ½, and investors sometimes see this as a green light to start utilizing those funds. For most people that age, retirement is still a few years away, and they’d be better served leaving the cash in a tax-favored account to continue growing until they hang up their work clothes.

3.     Not paying attention to fees. New regulations mean that investment firms have to clearly disclose fees associated with their funds to 401(k) investors, but research shows that many investors don’t pay attention to such disclosures. That’s a huge mistake: Even small fees can really eat into your profits over time. Look for funds that carry fees of no more than 1 percent.

4.     Making the wrong investments. Having the wrong asset allocation can limit your ability to grow or protect your nest egg. See if your plan provides online or one-on-one investing advice to employees as part of their benefit package—57 percent of company plans do, according to SHRM. If you don’t have access to such guidance, try using an asset allocation tool online, or go with a target-date fund that will automatically rebalance for you based on your expected retirement date.

Some employers allow workers to purchase company stock with their 401(k) funds. No matter how great you think your company is, limit that investment to no more than 5 percent of your portfolio.

5.     Cashing out. Even if your 401(k) hasn’t added up to much before you leave your job, resist the urge to drain it when you leave, which will cost you a boatload in taxes and fees. With the rate at which workers today change jobs (the average worker holds 11 jobs between the ages of 18 and 46, according to a 2012 study by the Bureau of Labor Statistics), that can become an expensive habit.

Related: Americans’ 401(k) Totals Just Reached a New Record. Don’t Celebrate Yet…

Instead, roll the funds into an IRA or your new 401(k), to make it easier to keep track of that money. “Remember, you’re not just taking out a small balance now, you’re taking out a multiple of that amount that could have grown through 30 years of compounding,” says Bruce Elliott, manager of compensation and benefits at the Society of Human Resource Management. An account with just a $2,500 balance, for example, would be worth more than $10,000 after 30 years, assuming a conservative 5 percent annual rate of return.

6.     Borrowing against it. It can be tempting to take advantage of the option many 401(k) plans offer participants, to borrow a certain amount of money at below-market rates. A February report by the Investment Company Institute found that 18 percent of defined contribution plan participants had an outstanding loan against their account. 

Proceed with caution. While you’re paying back the loan, you’re missing out on any gains you could have earned with that money. Plus, if you lose your job or choose to leave, most plans require you to immediately pay back any outstanding loans or pay a penalty.

7.     Ignoring the Roth 401(k) option. More than half of companies offer an option to make Roth 401(k) contributions, but less than 11 percent of employees take advantage of these features, Towers Watson reports.  These accounts allow investors to pay taxes upfront on the contribution but make tax free withdrawals in retirement. 

Unlike a Roth IRA, there are no income limits on Roth 401(k) contributions. For high earners, that’s an opportunity to pay potentially lower taxes now on money they’ll use later. “Higher earning young people might not be clued into that option,” says Katherine Roy, chief retirement strategist at J.P. Morgan Asset Management.

Top Reads from The Fiscal Times:

TOP READS FROM THE FISCAL TIMES